China's economy in need of a new wave of reforms to avoid contraction
Ha Jiming says China needs a repeat wave of reforms like those of the late 1990s. Targets today should include industrial inefficiency, and its outdated tax and social security policies
Vice-Premier Li Keqiang said at a recent State Council seminar that "reforms are China's greatest dividends". Indeed, a review of China's economic performance in the past two decades shows that reforms played a critical role in lifting China's growth potential. There is no doubt that low labour costs contributed to China's rapid economic expansion during the period, but this demographic dividend was not the sole engine of growth.
Rapid fiscal and monetary expansion spurred short-term growth in 1992-93, but excessive bank credit and investment led to high inflation and overcapacity in many industries, lowering the country's growth potential up to 1998. Then, in the next three years, China rolled out important structural reforms aimed at improving efficiency and identifying growth drivers.
Reforms of state-owned enterprises and privatisation from 1998 broke up vested interests and made the industrial sector more efficient. Housing reforms introduced that year unleashed tremendous pent-up demand for property and provided impetus to the economy, particularly in housing-related industries.
China's accession to the World Trade Organisation in 2001 provided a further boost to manufacturing and brought international competition that forced domestic enterprises to improve efficiency.
These reforms set the stage for economic acceleration while keeping inflation under control. The economy grew strongly for a decade. By 2007, benefits from these reforms began to dissipate as inflation picked up, but no new substantial reforms were introduced. Instead, the government launched massive fiscal and monetary stimulus in 2008-2009 to counter the impact of the global financial crisis. While this package failed to raise growth potential, it led to a short-term rebound at the cost of soaring property prices and serious overcapacity problems that impeded growth in the following years.
We expect China's growth potential to decline in the absence of fundamental reforms, given that its demographic dividend will soon become a deficit requiring greater public spending on social welfare.
China is badly in need of economic reforms like those of the late 1990s to improve economic efficiency and identify new growth drivers. Judging from Li's comments, we believe a number of policies are being contemplated.
One of the most likely reforms would address the household registration system, or hukou, which is key to China's urbanisation. China's cities have large populations of rural migrant workers whose household registrations apply to their home villages in the provinces, not the urban areas where they live and work. As they are not entitled to benefits of the urban social security system, they must save as much as they can and are reluctant to consume. Abolishing the hukou system would unleash suppressed consumption and drive investment in housing and public infrastructure, which will help absorb excess production capacity.
Reform of the service sector may also be on the agenda. In China, spending on services represents only 20 per cent of total consumption, compared to more than two-thirds in the US. Many of China's service industries including health care, tourism and entertainment are expected to become more open to private investment.
China's business tax, one of the impediments to the development of the country's services industry, may be converted into a value-added tax (VAT). Such conversion began in Shanghai in January and has since been expanded to 10 other cities and provinces. It is expected to be implemented across the country in the future.
Another area for reform is developing the less-developed regions. Convergence in economic growth across regions is key to achieving China's new target of doubling its gross domestic product and per capita income from 2010 to 2020. Faster growth in low-income regions will help rebalance the economy towards consumption, given the higher propensity to consume in these areas.
Income redistribution will also be a priority to reduce the wealth gap, which is high and still rising. We estimate that China's annual per capita income growth was 1.9 per cent lower than real GDP growth between 2000 and 2010. Extrapolating to the next decade, a 7 per cent average annual GDP growth target would imply lower income growth, making the target of doubling per capita income challenging. Income redistribution measures will be needed to meet this target and that of doubling GDP.
Li emphasised the importance of using "incremental interests" to soften resistance to reforms. Our understanding is that, because of the difficulty in breaking up existing vested interests, more emphasis will be placed on development and expansion in areas that do not pose a direct or immediate challenge to these interests.
An example would be the development of capital markets and other direct financing channels to reduce overreliance on bank lending, instead of narrowing interest margins for banks. Another example would be allowing and encouraging private investment to reduce the influence of state-owned enterprises.
Gradualism, not shock treatment, still sets the tone for future reform. This is demonstrated by the emphasis on the importance of pilot programmes in carrying out major reforms. In that vein, we believe it is increasingly likely that the property tax pilot programmes launched in Shanghai and Chongqing last January will be expanded to other parts of the country. Introducing a property tax will increase the probability of existing purchase restrictions being phased out.
Dr Ha Jiming is vice-chairman and chief investment strategist of Goldman Sachs' Investment Management Division, China